In a new legal setback for the mortgage lending industry, a federal appellate court has denied a petition for a re-hearing of the controversial "Culpepper" decision, sending the case to trial or settlement. Lawyers for the plaintiffs -- borrowers who believe their lender paid illegal kickbacks to their broker -- plan to ask the trial judge today to rule for the borrowers without further hearing.

Estimates of the cost of a class action judgment against the lender, Irwin Mortgage Corp., go as high as $135 million, covering 30,000 home mortgage customers.

The major issue in the case involves what are known as "yield spread premiums" -- fees that are commonly paid to mortgage brokers by lenders after delivery of a new home loan. Yield spread premiums are paid when the mortgage delivered carries an interest rate above the lender's "par" or standard posted rate.

Lenders and brokers defend the fees as important tools to allow cash-short borrowers, especially new home buyers, to obtain a mortgage without paying heavy closing costs up front. They also argue that yield spread premiums are essential compensation to brokers, helping them cover their ordinary costs of doing business.

Critics, on the other hand, say the fees often allow unsuspecting borrowers to pay higher rates than they should. They say that the payments often amount to referral fees or kickbacks, prohibited under the federal Real Estate Settlement Procedures Act (RESPA).

In the Culpepper case (Culpepper vs. Irwin Mortgage Corp.), John and Patricia Culpepper claim that the $1,263 yield spread premium their mortgage company paid their broker represented an illegal kickback under federal law. Unlike a "no-cost" mortgage, where the borrowers knowingly pay a higher interest rate in order to finance their closing costs, the Culpeppers say they knew nothing of the fee, and believe the sole reason the lender paid it was in exchange for an above-market interest rate.

Since the fee from the lender required no extra work by the broker, and the lender paid premiums according to a sliding schedule that rewarded brokers with higher fees for delivering higher-rate loans, the payment in their case amounted to an illegal referral fee, according to the Culpeppers.

Though the fee involved is relatively small, the Culpepper case -- and the possibility of a large jury award or settlement -- has had the entire mortgage industry on pins and needles this summer.

Yield spread premiums are so ingrained in the current mortgage origination system--and so useful in many situations -- that mortgage lenders feel any broad-brush federal court judgment could be extremely damaging. Equally important, they say, any decision against them would prompt dozens of similar class actions against the largest and most prominent lenders in the business.

The Mortgage Bankers Association of America has provided legal assistance to Irwin, and has mounted a vigorous, behind-the-scenes campaign to convince the Department of Housing and Urban Development (HUD) to issue some type of statement re-emphasizing its position that yield-spread premiums are not , in and of themselves, illegal kickbacks.

In a "Statement of Policy" on the subject two years ago, HUD said the legality of yield spread premiums depends on whether the payments are properly disclosed to the borrowers, and are reasonably related to services or goods performed by the mortgage broker.

Mortgage brokers are particularly upset by the prospect of a negative decision that would force major lenders to curtail or modify yield spread premiums.

"This is the way I get compensated for the work I do and the overhead I have to pay for," said one Maryland brokerage executive who asked not to be identified. "I've got to pay for my office rent, my staff, my equipment and all that," he said. "Brokers like me function as the retail branches of the big lenders. They (the lenders) don't have to pay for that brick and mortar, but I do.

"If the courts say yield spread premiums are illegal, I'm still going to have to paid for my work." The broker said he calculates that on average, he needs to make $4,000 for every new loan he originates. "Somehow we're going to have to charge it" -- either through new fees or through higher rates.

Lawyers familiar with the case say the trial judge is likely to rule on today's motion for summary judgment within weeks. If the case goes to trial before a jury that sides with the Culpeppers, the financial costs and legal ramifications for mortgage lenders and borrowers alike could be huge.

For more articles by Ken Harney, please press here.

Published: August 27, 2001

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.